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Road Map to a Growth Economy

August 17, 2011

Over the weekend, Jackie Calmes penned an “economic memo” in the New York Times that was critical of conservatives’ opposition to tax increases. The piece relied on selective quotes from conservative economists, sell-side forecasters, and some academics to undermine the basic conservative approach to fiscal policy. The piece suffers from two main flaws: (1) it suggests a consensus where none exists on the potential benefits of near-term stimulus; and (2) it treats all forms of revenue increases the same, despite the dramatic differences in economic consequences and the potential revenue gains from the economic growth unleashed by broad-based tax reform.

In the first case, Calmes parrots the familiar line that fiscal consolidation in the U.S. is moving too rapidly. At this stage of the economic cycle, “Washington should be focusing on stimulating the economy in the near term to induce people to spend money and create jobs, while settling on a long-term plan for spending cuts and tax increases to take effect only after the economy recovers.” Surely everyone wishes that the economy were growing more rapidly today than it is. The problem is that fiscal stimulus is hardly a reliable mechanism to deliver faster growth in the near term, but it worsens the long-term debt problem with virtual certainty.

Despite Calmes' suggestions to the contrary, it is not at all clear that the 2009 stimulus did anything to boost real output. The analyses that claim it did are non-falsifiable – and therefore largely meaningless. They are non-falsifiable because they get the same results before and after the natural experiment and are entirely dependent on assumptions. Moreover, the economy obviously failed to take the path forecast by the incoming Administration in 2009 when they argued employment would not exceed 8% with the stimulus. Does this mean the stimulus failed? It depends entirely on one’s assumptions about the impact of different spending on growth. It is just as easy to argue – as the Administration has – that the recession was simply much worse than they anticipated. Early evidence that relies on geographic data suggests that the stimulus cost about $400,000 per job, with infrastructure spending comparatively much more efficient than aid to states and other programs. Even this may be charitable though as the most likely counterfactual in the absence of stimulus is exactly the same amount of government purchases financed by more state and local government borrowing instead of federal borrowing.

Given this background, it is surprising that anyone would believe (with such conviction) that the current economic malaise calls for more discretionary stimulus or a slower pace to fiscal consolidation. The U.S. economy does not need a near-term boost, but rather a coherent policy or strategy to support investment and long-run growth. Even if fiscal stimulus succeeds, it normally does so through government purchases and increases in household consumption expenditures through transfer payments. Yet, until the second quarter of 2011, economic weakness had been concentrated in business investment. All other major components of GDP have exceeded their 2007 peak (in real terms). Business investment not only remains below 2007 levels, it also has been unable to make up for the net contraction of the capital stock that occurred in 2009 when depreciation exceeded investment by a large amount in a stalled economy. The economy is not only operating below its potential – the recession actually lowered potential GDP as well (largely due to the decline in business investment).

While investment in early 2009 may have been subdued due to a lack of access to capital, eventually businesses built huge cash positions in late 2009 and into 2010. Cash and cash equivalents on businesses’ balance sheets continue to set records each quarter, with more than $1.023 trillion held by the S&P 500 corporations alone. What is causing businesses to delay and cancel investment and sit on large cash positions? It is likely a function of the uncertainty plaguing the economy, which is only intensified by trillion dollar deficits, unconventional monetary policy, and a muscular regulatory regime.

By embracing a fundamental re-write of corporate and individual taxes, many conservatives today are offering a fiscal policy that is more stimulative than any suggested by Calmes. As Glenn Hubbard explains in a recent op-ed in the Wall Street Journal, tax reform is the best step government could take now to promote economic growth. Hubbard cites recent public finance research that finds broadening the tax base and sharply lowering marginal tax rates can raise gross-domestic-product growth by a half to a full percentage point per year over a decade. Each year, OMB includes in its Analytical Perspectives a chart (p. 23) measuring the sensitivity of the deficit projections to changes in economic growth. A sustained 1 percentage point increase in GDP for ten years is likely to reduce the deficit by $3.2 trillion over ten years, with $2.8 trillion in higher revenues and $350 billion in lower spending due to higher levels of employment and less social welfare spending. This faster growth comes from less distortions to economic decision-making, lower marginal rates on income to reduce the government’s share of additional work, savings, investment, and the confidence generated by greater certainty with respect to the future of fiscal policy.

While tax reform can generate more revenue, both because of the larger economy and because of the net revenue generated from closing loopholes, the data are clear that as much of the adjustment should take place on the spending side as possible. Indeed, there is more consensus on this point than any other topic addressed in Calmes’ piece. She hints at this by noting that “some studies by both liberal and conservative economists suggest that emphasizing spending cuts is better for long-term growth.” As ECB President Jean-Claude Trichet summarized in explaining the current state of research:

The success of a fiscal consolidation strategy strongly depends on its design. Adjustment on the spending side, accompanied by structural reforms to promote long-term growth, has typically been the best strategy, especially when combined with a credible long-term commitment to fiscal consolidation.

This is also the conclusion of previous work at the IMF:

Of the 17 cases in which most of the adjustment took the form of expenditure reductions, just under half were successful, while among the 37 cases where the consolidation was achieved mainly by raising taxes, less than one out of six had successful outcomes. The message is reinforced by the fact that the average structurally adjusted expenditure cut in the successful episodes was 3.7 percent of GDP, while in the unsuccessful cases it was only 2.1 percent.

Despite the evidence, Calmes mentions that there are few precedents for paying down debt through spending cuts alone. But this is due to political, rather than economic reasons. In the current debate, tax increases are viewed as a “cost of doing business” with the Administration on deficit reduction, but this has nothing to do with the economics. When looking at the long-run budget situation, revenues are expected to climb well above their historical average of about 18.5% of GDP within the next ten years. In fact, as CBO notes in its 2011 Long Run Budget Outlook, current law already builds in more massive tax increases on American households than has been contemplated by any previous Congress in history. Although revenues have historically “average[ed] 18.0 percent [of GDP], with no evident trend over time,” under current law:

Revenues would rise from about 15 percent of GDP in 2011 to nearly 19 percent in 2013, about 21 percent in 2021, and about 23 percent in 2035, for a total increase of more than 8 percentage points over that period. By 2035, the tax system would be quite different from what it is today. Households at all points on the income scale would pay a higher share of their income in taxes than similar households pay today, and a much larger share of households—nearly half—would be subject to the AMT.

The new phenomenon driving the deficit is entirely on the spending side, with current spending one-quarter larger as a share of the economy as has been the U.S. historical experience. Future deficit growth is driven almost entirely by entitlement spending. If one assumes that revenues are slightly above their long run average (18.4%) over the next 25 years and no changes are made to entitlement programs, the public debt grows from 70% of GDP currently to 187% in 2035. The money available on the revenue side is trivial compared to the entitlement explosion, even if one wishes to take tax receipts to never before seen levels.

For these reasons, e21 stands with Stanford economist John Taylor on this question of fiscal consolidation. Calmes quotes Mr. Taylor in her piece as saying that temporary stimulus measures have been “counterproductive, and for long-term debt reduction, ‘I would try very hard to make it work without revenues.’” There is no economic consensus for short-term stimulus coupled with long-run “balanced” deficit reduction. Near-term growth and long-run deficit reduction depend equally on tax reform and sharp reductions in planned entitlement outlays.

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